Homeowners race to beat gift-tax expiration

AnnaMariaAndriotis

Want to give the kids a little something extra for the holidays? Get going. The generous lifetime gift-tax exemption—in which couples can give up to $10.24 million to descendants tax free—expires at the end of the year.

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The lifetime exemption will drop to $1 million for individuals (from $5.12 million) and to $2 million for couples (from $10.24 million) if Congress doesn’t intervene. While some experts expect Congress to act, they think the resulting cap will still drop.

So for wealthy families, there’s a limited window to give sizable assets—including real estate—to children while avoiding a tax hit.

“It’s been an instigator for our clients to take action,” says Andy Berg, chief executive of Homrich Berg, a wealth-management firm in Atlanta.

Jeff Sica, a financial planner in Morristown, N.J., owns multiunit properties in several cities, including Denver and Houston. While he knew he ultimately would gift them to his three children, the changing tax landscape accelerated his plans. Earlier this year, he moved some of the properties into a trust.When Mr. Sica dies, those properties won’t be subject to an estate tax, saving his heirs hundreds of thousands of dollars. “We have the ability to gift a lot more now than in years to come,” he says. “If you can gift in advance, why would anyone wait?”

The current exemption is part of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. That law includes the higher lifetime limits, as well as a relatively low 35% maximum tax rate on gifts that exceed these limits. Come Jan. 1, gifts over the limit are set to hit a maximum 55% tax rate.

Wealthy families have been taking various measures to prepare for lower exemption limits and higher tax rates. Some people gift properties using a separate vehicle, such as a limited-liability company or a trust. These allow parents to maintain some control, and since these vehicles can minimize the value of the gifts, parents can maximize the lifetime gift-tax exemption elsewhere.

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Sarah Kerr Severson, a partner who specializes in estate and gift planning at law firm Schiff Hardin LLP, headquartered in Chicago, says many of her clients with real-estate investments often opt for an LLC. These have an added benefit. When buildings are owned by several family members through an LLC, they’re not as marketable as when one person owns them outright. If one relative sells his share of the family-owned LLC, an outsider could be less inclined to buy since he’ll have to negotiate with a group of other, related LLC members.

That’s what is called a “lack of marketability,” under which appraisers can apply a discount of up to 15% to 20% on a property’s valuation, says Erin Fukuto, a partner with accounting firm Raimondo Pettit Group based in Torrance, Calif. So properties that would be appraised at $12 million could be valued as $10.2 million for gifting purposes, within couples’ lifetime-exemption threshold. There can be another potential appraised discount of up to 15% if the children are receiving a minority interest in the properties.

When gifting a primary residence, Mr. Berg says that many of his firm’s clients set up a qualified personal residential trust, which allows parents to retain control of the property and remain in the residence for the number of years they choose. It also helps discount the property under what’s called a “present value factor” since the child won’t actually receive the property for a while. So, the property’s value that counts against the parents’ lifetime exemption will actually be lower than its appraised value. The discount will depend on several factors, including the period parents choose and their age when the term ends; for example, by applying the present-value factor, a $2 million residence gifted this month by a 60-year-old parent who retains control of it for 10 years would be roughly $1.5 million, says Ms. Fukuto.

The strategy isn’t without pitfalls. If parents die before the allotted period ends, the property will return to the estate and ultimately incur the estate tax. If parents outlive this period, they’ll have to move out of the home or start paying rent to the trust.

Here are other strategies:

Get around the deadline. It can take months to gift a home, since it requires a home appraisal and changing the title on the property, leaving parents at risk of missing the deadline, assuming tax changes do indeed take effect in January. But certified financial planner Stewart Welch says he has been working with clients to transfer publicly traded stocks into trusts—often a one-day transaction—and adding language to the trust that allows parents to swap those securities with real estate of the same value next year.

Gift cash toward real estate. Parents can also use the lifetime gift-tax exemption to gift cash to their children that would help them with a home purchase. They can also gift the remaining balance on a loan they may have previously given their children. When Marv Pollack of Chicago purchased his home seven years ago, his mortgage was provided by his father rather than a bank. With the higher lifetime gift-tax exemption nearing an end, his father decided to gift the balance of the mortgage, reducing the value of his estate.

You want to continue using the property. Tom Bentley, principal at Truepoint Inc., a fee-only wealth-advisory firm in Cincinnati, says he’s working with a client who gifted 10% of the value of his vacation home to a child in an irrevocable trust, with the child serving as the trustee. The trust, under the direction of the child, then bought the entire home from the parent, returning the 10% down payment and borrowing the remaining 90% from the parent. The parent, who retains the home, pays rent to the trust. The child uses those payments to pay back the parent what he owes on the loan. Under this scenario, a $1 million home can be given to an heir in trust but only 10%—or $100,000—of its value would count as part of the lifetime gift-tax exemption.

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Exclusion vs. Exemption

An annual exclusion that allows people to give away as much as $13,000 per year (or $26,000 for married couples) to a relative or friend or any other people. This does not expire Dec. 31; in fact, the cap is expected to rise to $14,000 ($28,000 for married couples) in 2013.

A lifetime exemption in which an individual can give up to $5.12 million to descendants tax free. (The limit for couples is $10.24 million.) Those levels are expected to expire Dec. 31, bringing the limit to $1 million for individuals and $2 million for couples.

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